THE DETERMINANTS OF BANKING SYSTEM VULNERABILITY …fs.icfm.ro/vol17i4p8-21.pdf · THE DETERMINANTS...

8

THE DETERMINANTS OF BANKING SYSTEM

VULNERABILITY IN THE REPUBLIC OF MOLDOVA

Dorina CLICHICI PhD

Abstract A banking system is more vulnerable when there are felt

more negative effects on this as a consequence of the global financial crisis events In the context of the objective of enhancing financial stability and in particular limiting the likelihood of failure of the banking system it is useful to verify how the main characteristics which play a role for banking system vulnerability behaved in the case of the Republic of Moldova systemrsquos liquidity capitalization competition diversification presence of foreign banks and wholesale funding In order to determine how hard was hit the banking system of Moldova by the recent financial crisis in the article are analyzed quantitative and qualitative the above mentioned characteristics and identified the crisis effects on them

Keywords financial crisis banking system liquidity capitalization competition diversification foreign banks wholesale funding

JEL Classification G01 G21

1 Introduction The globalization of banking activity determines that shocks

affecting a particular bank or country can now affect not only the local real economy but also the financial system and real economy in other countries Thus the banking systems are more vulnerable to shocks and to contagion now then ever This contagion effect was felt the most at the beginning of the financial crisis (2007-2009) which started with the bursting of the US housing bubble and the subsequent increase in subprime mortgage loan default rates as triggering the global financial crisis The critical turning point was when the US government refused to save the financial services firm Lehman Brothers from its collapse on September 15th 2008 This bankruptcy shocked market confidence and caused financial panic

National Institute for Economic Research Chişinău Republic of Moldova

Financial Studies - 42013

9

The effects of the crisis rippled further throughout the highly interconnected and overleveraged global financial system In the months thereafter what started as liquidity problems transformed into greater solvency concerns about important global financial institutions (Claessens et al 2010) Eventually also consumers and firms faced a credit stop leading to falls in consumption and investment and a real sector slowdown in the US and Western Europe Thus a systemic economic crisis was born

Later the crisis has spread to the developing countries through the holding by developing country banks of the same toxic assets that troubled Western banksrsquo balance sheets or through investments in foreign financial institutions that held such assets Direct contagion was however limited in most developing countries due to modest foreign bank penetration (with the exception of CEE countries) and low financial sector complexity As a result emerging and other developing economies were largely insulated from the crisis for some months in part explaining initial optimism about decoupling The consequences of the crisis for these countries only became noticeable with a lag from September 2008 onwards Most analyses (Dooley and Hutchison 2009) identify four more indirect channels of transmission as most important trade private capital flows remittances and international bilateral aid Republic of Moldovarsquos economy was affected through two indirect channels trade and remittances The downturn of these two variables due to the worsening of the economic situation in the country has worsened the borrowersrsquo financial situation which damages in its turn the banking system

The methodological base of this research includes in particular qualitative and quantitative analysis of characteristics proposed by Degryse (2013) which play a role for banking system fragility systemrsquos liquidity capitalization competition diversification presence of foreign banks and wholesale funding In order to determine how hard was hit the banking system of Moldova by the recent financial crisis it is useful to verify the relation between the above mentioned characteristics and the crisis effects and to detect in this way the main channels of crisis impact


10

2 The characteristics of Moldovan banking system vulnerability

The financial sector of the Republic of Moldova is dominated by the banking system which accounted for 93 of total financial assets and 96 of total loans provided by the financial sector at the end of 2012 The local banking system has a low degree of connectivity to European and world banking system due to a very low presence of international banks on the market1 which has determined no direct contagion within the last financial crises The effects of the crises were felt indirectly by the banks through the channel of remittances and foreign trade which have diminished substantially as a result of economic decline in Europe The decline of private consumption in the euro area has contributed to the decrease in Moldovan exports to EU and of the volume of remittances in 2012 Thus the general effect of the financial crises on the Moldovan banking system was felt on the banksrsquo asset side The mentioned tendencies have negatively influenced creditworthiness of Moldovan borrowers and respectively the quality of local banksrsquo loan portfolios There are also some structural shortages which increase the fragility of the local banking system

Taking into consideration the characteristics of banking system fragility proposed the following effects of the financial crisis on them were indentified

a Capitalization and liquidity A higher capital base provides a cushion against insolvency

and helps in reducing possible contagion effects from individual bank failures in the same country or region The liquidity on a bankrsquos balance sheet serves as a first line of defence against liquidity shocks and enhances the stability of the domestic banking system The average capital adequacy and liquidity ratio of the Moldovarsquos banking system recorded for 2006-2013 indicates a high degree of banks safety and the potential to perform risky operations without affecting the capital (figure 1) Among countries from Eastern Partnership and some EU countries with similar size

1 There are only 4 banks with 100 foreign capital of 14 commercial banks

operating in the local banking market


11

and economic problems Moldova has the highest level of the capitalization and liquidity2

Figure 1 - Capital adequacy and current liquidity ratio ()

Source National Bank of Moldova database 2006-2013

Nevertheless these indicators dropped slowly after 2009 Thus the effects of the global financial crisis were felt by the Moldovan banking system even if the capital and liquidity ratios were significantly higher then the Basel requirements and the values required by National Bank of Moldova3 The studies of Degryse (2013) suggest that increases in capital do have an effect in reducing bank fragility but only when capital levels are higher than a threshold of around 7 Taking into consideration higher values of capital and liquidity ratios in Moldova I could assume that the banking system is relatively resilient to the crisis

2 World Bank and IMF data base Financial Soundness Indicators tables 2009-

2013 3 The minimum capital adequacy ratio established by National Bank of Moldova

is 16 (from June 2012) until then it was 12 The minimum current liquidity

ratio is 20


12

b Competition concentration and presence of foreign banks Existing cross-country studies (Demirguc-Kunt and Levine

2005 OECD 2010) focusing on systemic stability find a positive effect of both competition and concentration on stability As the study suggests the positive effect of concentration on stability is likely to depend on better possibilities for larger banks to diversify risk The main findings focusing on systemic stability are

Bank concentration is (robustly) negatively correlated with financial crises That is more concentrated banking systems are less vulnerable to systemic banking crises are those systems (OECD 2010) There are suggestive evidences (Demirguc-Kunt and Levine 2005) that concentrated banking systems tend to have larger better-diversified banks which may help account for the positive link between concentration and stability

The likelihood of a financial crisis is lower in countries where regulation allows more entry foreign ownership and a wider range of activities and where the institutional conditions stimulate competition The presence of foreign banks in a region may impact the fragility of the regional banking system in different ways On the one hand a greater foreign bank presence may lead to greater banking efficiency and competition in the domestic financial system On the other hand foreign banks may provide a channel for cross-border contagion when they transmit shocks from one region to another Empirical studies have shown that by improving overall operating efficiency foreign entry helps create the conditions for better financial intermediation and long-term growth (Claessens et al 2000)

Concentration ratios of the Moldovan banking system range between 60 and 70 per cent for the largest five banks in the system (figure 2) and suggest that Moldova has a moderately competitive system with oligopoly tendencies


13

Figure 2 - Structural indicators of the Republic of Moldovarsquos banking system end of the year

Source National Bank of Moldova data base 2006-2013

The graphs suggest that the level of concentration of the local banking system have slowly increased after 2008 which in accordance with the findings of Demirguc-Kunt and Levine (2005) has lead to a decreasing of the systemrsquos vulnerability It is also a result of the orientation of the banksrsquo clients toward the biggest banks of the system with higher visibility After 2008 two small banks from sixteen have been hit hard by the crisis and became insolvent It might be concluded that in case of the Republic of Moldova as in case of Canada and Australia a more concentrated financial system is more resilient to financial distress and the biggest banks has bigger capacity to face the risks due to higher capitalization and liquidity

Regarding the foreign ownership aspect while foreign participation is considerable (share of foreign investments in banksrsquo capital recorded at the end of 2013 was 722 ) the majority of foreign holdings in Republic of Moldova belong to investors that are not internationally highly-rated financial institutions with a significant percentage of the owners being residents in offshore centres While those owners who have more than a 5 stake in a bank have been mostly found to be fit and proper the ability and willingness of such owners to provide know-


14

how and capital or liquidity support is not obvious On the other hand the low presence of foreign banks on the local banking market has protected it from the contagious effects of the crisis

The structural vulnerabilities of the Moldovan banking system are the following

(i) Uncertainties in the ownership structure still remain vulnerability despite considerable efforts of the NBM4 The process of clarifying the ultimate beneficial owners has not been completed This raises concerns in relation to large exposures connected lending and loan concentration and in establishing whether the owner can provide contingency funds in case of a bank run or other stress situations

(ii) Foreign strategic investors5 own less than 20 of the banking sectorrsquos assets The investments of first-tier banks in Moldova are welcome The main arguments for this are the implementation of highly efficient risk management practices within the local banking system and the injection of long term financial resources in the Moldovan economy The supervisors should continue to exert pressure on the banks to consolidate ownership in individual banks through strategic investors

c Funding structure The recent financial crisis has shown that banksrsquo funding

structure is important to their resilience Banks can finance themselves with both depository funding and wholesale funding (ie funding from other banks money market funds corporate treasuries and other non-bank investors) relying mostly on wholesale funding have been severely affected by the crisis Banks in Australia and Canada for example have been very resilient to the crisis because they have relied mostly on depository

4 The threshold for significant shareholding was reduced to 5 from the

previous 10 Banks are obliged to submit information on their shareholders

exceeding this limit In case of noncompliance the NBM limits the operations of

the banks that do not support the enforcement of the regulation In addition the

NBM requires that information be provided on shareholders with holdings

between 1-5 This requirement attempts to prevent connected parties from

circumventing the regulation by splitting holdings into portions not exceeding

5 5 BC bdquoMobiasbancă ndash Groupe Socieacuteteacute Geacuteneacuteralerdquo SA BC EXIMBANK-

Gruppo Veneto Banca SA BC ProCredit Bank SA BCR Chișinău SA


15

funding much of which came from retail sources such as households (OECD 2010) Reliance on non-core deposits as a funding source wholesale funding could prove to be a more volatile source of funding that may accentuate regional banking fragility

Moldovan banks demonstrate a high level of resilience to the crisis due to their funding structure They finance themselves with both depository funding and wholesale funding but they rely mostly on depository funding Deposits to liabilities ratio reached the amount of 854 at the end of 2013 much of which came from retail sources (figure 3)

Figure 3 - Funding structure of the Moldovarsquos banking system end of the year


It was recorded a sudden drop of deposits to liabilities ratio in 2009 as a result of remittancesrsquo and trade revenues decreasing Another indicator - loans to deposits ratio - has recorded a sudden drop in 2007 till 2009 and still remains at a low level These tendencies suggest that Moldovan banks have a strong preference for maintaining liquidity during the financial crisis This is mostly due to the uncertain macroeconomic outlook and the recent history of banking sector instability

However the intermediation function of Moldovan commercial banks is undermined although the level of liquidity in


16

the system is one of the largest in the region they are very cautious in granting loans The central issue of undermining is the mutual crisis of confidence of the individuals and companies towards banks and of commercial banks towards potential borrowers It explains the conservative approach of local banks risk management the reluctance in their lending activity and the maintenance of a high level of liquidity This conservative approach has become even more acute during the recent economic crisis It reveals that the lack of resources is not the essential issue of passive lending and the high level of liquidity may be a consequence of this reluctance to credit activity

d Diversification Whether diversification in banking activities leads to

financial stability or increase the vulnerability is a question addressed in many research studies (Stiroh 2006 Baele De Jonghe and Vander Vennet 2007 Laeven and Levine 2007 Schmid and Walter 2009) Various financial innovations were conceived in the early 2000s as ways to improve risk sharing and risk management However they led to increased leverage and risk taking Banks introduced a wide range of new instruments to transfer credit risk Initially these instruments allowed banks to gain very large spreads Then they substantially decreased due to global competition involving not only banks but also other financial institutions De Jonghe (2010) finds that banking system fragility aggravates when a bank engages in non traditional activities Since interest income is less risky than other revenue streams it is argued that specialization in traditional activities result in lower systemic banking risk It is theoretically argued that even though diversification may reduce risk of the individual bank from the financial systemrsquos point of view it may increase the likelihood of systemic crisis as diversifying banks become more similar In case of the Republic of Moldova banks do not use such a wide range of financial innovations as the banks from developed countries These preferences for traditional activities that generate incomes have contributed to a higher level of resilience during the recent financial crisis The level of diversification determined by the ratio of loans to total assets has recorded a high level 623 in 2012 demonstrating the Moldovan banksrsquo focus on traditional loan-making activities


17

e Others sides of vulnerability Vulnerabilities also could arise on the banksrsquo asset side

The worsening of the economic situation due to the crisis in the country (GDP has decreased in 2008 by 08 ) has worsened the borrowersrsquo financial situation which damages in its turn the banking system Thus a high level of bad loans (127 in 2013) became an alarming feature of the domestic banking sector (figure 4)

Figure 4 - Nonperforming loan and provision for loan losses ratio


Economic crisis in 2009 caused a significant increase in non-performing loans from 59 in 2008 to 163 in 2009 Sudden increase of credit risk during this period led banks to restrict lending and to significantly increase the allowances for loan losses With few exceptions the trend of deterioration in loan quality continued to be a common feature for the European banking market in 2012 due to sovereign debt crisis

In addition to the mentioned above characteristics of the banking system vulnerability to crisis Moldovan banking system is highly sensitive to macroeconomic changes and expectations showing a pro-cyclical character Given the pro-cyclical nature of the banking system relatively favourable macroeconomic situation in Moldova recorded in 2013 was fully reflected in increased banking credit activity (figure 5) While this credit growth is from a


18

very low economic base possibly reflecting catch-up growth a continued increase will require careful attention to pre-empt deterioration in banksrsquo credit portfolios

Figure 5 - Credit growth rate and GDP growth rate


The danger is now that the banksrsquo internal risk management systems are not good enough to pre-empt nonperforming lending In this context it would be useful for the NBM to develop an early warning system that would signal any emerging macro prudential risks to the financial system

Another characteristic of the Moldovan economy which increases the vulnerability of the banking system is the dependence on remittances It is one of the highest in the world (245 of GDP) and enhances the financial system vulnerability to potential volatility in these inflows For 2012 Moldova ranks the fifth in the world (World Bank 2013) Thus the dependence on the economic conditions of the main destinations for Moldovan emigrants (Russia and the EU) could influence significantly the local banking system Should these conditions worsen or enforcement of immigration and labour laws in those countries tightened the inflow of remittances may slow down considerably This would put the exchange rate under pressure and diminish the availability of financial resources for the financial sector It could


19

also increase credit risk as part of bank lending is based on the borrowers earningreceiving remittances

3 Conclusions The main conclusions of the article in the context of

verifying how the main characteristics of the banking system vulnerability have behaved in the case of the Republic of Moldova are the following

Taking into consideration higher values of capitalization

and liquidity of the banking system in Moldova the assumption is

that it is relatively resilient to the crisis

The level of concentration of the local banking system

have slowly increased after 2008 which in accordance with the

findings has lead to a decreasing of the Moldovan banking

systemrsquos vulnerability

The majority of foreign holdings in Republic of Moldovarsquos

banks belong to investors that are not internationally highly-rated

financial institutions with a significant percentage of the owners

being residents in offshore centers As e result the low presence of

foreign banks on the local banking market has protected it from the

contagious effects of the crisis

Moldovan banks demonstrate a high level of resilience

to the crisis due to their funding structure

In case of the Republic of Moldova banks do not use

such a wide range of financial innovations as the banks from

developed countries The banksrsquo preferences for traditional

activities that generate incomes have contributed to a higher level

of resilience during the recent financial crisis

Economic crisis has caused a significant increase in

non-performing loans Sudden increase of credit risk during this

period led banks to restrict lending and to significantly increase the

allowances for loan losses

Moldovan banking system is highly sensitive to

macroeconomic changes and expectations showing a pro-cyclical

character


20

Another characteristic of the Moldovan economy is the

dependence on remittances which is one of the highest in the

world and enhances the financial system vulnerability to potential

volatility in these inflows

An appropriate institutional structure is critical for preventing banking vulnerability in Moldova and for reducing their undesirable effects if they should occur NBM has made progress in developing and implementing a basic stress testing toolkit although the lack of capacity to change stress testing scenarios to accommodate newly emerging risk factors is vulnerability More work is needed to identify additional risk factors and properly assess credit and liquidity risks In this context it would be useful for the NBM to develop an early warning system that would signal any emerging macro prudential risks to the financial system

References

1 Claessens S Laeven L Igan D and DellAriccia G (2010)

Lessons and Policy Implications from the Global Financial Crisis IMF Working Papers1044 International Monetary Fund

2 Dooley M and Hutchison M (2009) Transmission of the US Subprime Crisis to Emerging Markets Evidence on the Decoupling-Recoupling Hypothesis JIMFWarwick Conference on April 6

3 Degryse H Elahi M A and Penas M F (2013) Determinants of Banking sytem fragility a regional Perspective ECB Working Paper Series no 1567

4 Demirguc-Kunt A Levine R (2005) Bank Concentration and Fragility Impact and Mechanics [Online] Available

httpwwwnberorgpapersw11500 5 OECD Competition Committee (2010) Competition

Concentration and Stability in the Banking Sector DAFCOMP [Online] Available

httpwwwoecdorgcompetitionsectors46040053pdf 6 Claessens S Demirguc-Kunt A and Huizinga H (2000)

How does foreign bank entry affect domestic banking markets Journal of Banking and Finance 25


21

7 Stiroh K and Rumble A (2006) The dark side of diversification The case of US financial holding companies Journal of Banking amp Finance 30 2131ndash2161

8 De Jonghe O Baele L Vander Vennet R (2007) Does the Stock Market Value Bank Diversification Journal of Banking amp Finance Vol 31 No 7

9 Laeven L and Levine R (2007) Is there a diversification discount in financial conglomerates Journal of Financial Economics Elsevier vol 85(2)

10 Schmid M Walter I (2009) Do Financial Conglomerates Create or Destroy Economic Value Journal of Financial Intermediation Vol 23

11 De Jonghe O (2010) Back to the basics in banking A micro-analysis of banking system stability Journal of Financial Intermediation Elsevier vol 19(3)

12 World Bank (2013) Migration and Development Brief April 19


9

The effects of the crisis rippled further throughout the highly interconnected and overleveraged global financial system In the months thereafter what started as liquidity problems transformed into greater solvency concerns about important global financial institutions (Claessens et al 2010) Eventually also consumers and firms faced a credit stop leading to falls in consumption and investment and a real sector slowdown in the US and Western Europe Thus a systemic economic crisis was born

Later the crisis has spread to the developing countries through the holding by developing country banks of the same toxic assets that troubled Western banksrsquo balance sheets or through investments in foreign financial institutions that held such assets Direct contagion was however limited in most developing countries due to modest foreign bank penetration (with the exception of CEE countries) and low financial sector complexity As a result emerging and other developing economies were largely insulated from the crisis for some months in part explaining initial optimism about decoupling The consequences of the crisis for these countries only became noticeable with a lag from September 2008 onwards Most analyses (Dooley and Hutchison 2009) identify four more indirect channels of transmission as most important trade private capital flows remittances and international bilateral aid Republic of Moldovarsquos economy was affected through two indirect channels trade and remittances The downturn of these two variables due to the worsening of the economic situation in the country has worsened the borrowersrsquo financial situation which damages in its turn the banking system

The methodological base of this research includes in particular qualitative and quantitative analysis of characteristics proposed by Degryse (2013) which play a role for banking system fragility systemrsquos liquidity capitalization competition diversification presence of foreign banks and wholesale funding In order to determine how hard was hit the banking system of Moldova by the recent financial crisis it is useful to verify the relation between the above mentioned characteristics and the crisis effects and to detect in this way the main channels of crisis impact


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THE DETERMINANTS OF BANKING SYSTEM VULNERABILITY …fs.icfm.ro/vol17i4p8-21.pdf · THE DETERMINANTS...

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